This tiny mutual fund is no. 1 for 2013

Lord Abbett Micro Cap Growth posted a 12-month return of 78.6%

By

SuzanneMcGee

It was a great year for broad stock-market benchmarks, but a downright fabulous one for shares of small, fast-growing companies.

That trend helped propel a fund that specializes in very small, very promising companies to the top of this newspaper’s quarterly ranking of the best 12-month performers among diversified U.S.-stock funds.

Scoring big in 2013 took “a strong stomach and a willingness to take risk, because there is huge money to be made when small growth stocks go on big runs,” says the fund’s lead manager, F. Thomas O’Halloran. (The fund’s shares are primarily offered to institutional investors, although there is also a share class for individual investors.)

Mr. O’Halloran’s win halted the four-quarter winning streak of Bill Miller’s Legg Mason Opportunity, which came in second for the 12 months through December, with a 68.0% gain. Another seven small-cap growth funds boasted returns in excess of 50% for the year, dominating the list of 2013 winners.

The Winners’ Circle ranking looks at funds with more than $50 million in assets and at least a three-year record; it excludes index funds, leveraged index funds and inverse leveraged index funds.

Small Was Big

In 2013, as stock-market investors shrugged off worries about economic growth, the Federal Reserve, Washington gridlock and other headwinds, small-cap growth stocks led the way higher through much of the second half. The S&P 500 index wrapped up the year with a gain of 31.7%, but the Russell Small Cap Growth Index gained 44.6%, while Mr. O’Halloran’s benchmark, the Russell Microcap Index, soared 46.5%.

Mr. O’Halloran hunts for “special companies,” which he says are rare and worth paying rich prices for: “They have outsize return potential, but the best also carry premium valuations. The market prices them at premiums to keep people away from them.”

Stocks that he is willing to own in the Micro Cap Growth portfolio can look pricey, but he calculates they’re cheap when measured against their potential over the next seven to 10 years.

In 2013, the corner of the market that repaid Mr. O’Halloran and several of his peers most lavishly was the biotech sector. A full eight percentage points of the Micro Cap fund’s outperformance over its benchmark, he says, is due to big leaps by companies like Acadia Pharmaceuticals
ACAD, -2.28%
(up 448%), Aegerion Pharmaceuticals
AEGR, +1.00%
(185% higher), Celldex Therapeutics
CLDX, +0.11%
(up 261%) and Puma Biotechnology
PBYI, -1.52%
(ahead 453%).

“Many early-stage biotech companies are achieving breakthroughs in rare diseases, in cancer therapeutics and other areas where the groundwork has been laid by genomics research,” Mr. O’Halloran says. Those research and product-development accomplishments show up rapidly in stock prices because of the interest shown by big pharmaceutical companies.

No. 3 in the 12-month ranking was Morgan Stanley Small Company Growth, up 61.9%. Like Mr. O’Halloran, Morgan Stanley manager Dennis Lynch had some big successes in the heath-care field. One winner: Athenahealth Inc.
ATHN, -0.16%
, which climbed 86%. Athenahealth offers a software platform for medical practitioners that makes it easier for them to collect payments from health-insurance companies. “They still have a low rate of market penetration, but if you dream a bit, it has the potential to be one of the biggest companies in its space,” says Mr. Lynch.

Long-Term Potential

That ability to look past premium valuations and instead focus on the long-term potential for “creative disruption” of traditional businesses is the common element for investors in small growth stocks. Over the course of 2013, Mr. Lynch tilted his fund’s portfolio to invest up to 60% of assets in these higher-growth businesses rather than the more usual 50%. “These are companies like Amazon in the large-cap arena that run their business almost as if they were private, making big investments today that may pay off in the future,” he says.

A case in point: CoStar Group
CSGP, +0.09%
, which provides the commercial-real-estate industry with proprietary information and which made a decision to invest heavily in expanding that database in new markets. “They wrecked their income statement in the short term, but it’s starting to pay off,” says Mr. Lynch. The stock was up 111% in 2013.

Innovation and turbocharged growth can come from more traditional businesses, too. Mr. O’Halloran’s holdings include Power Solutions International
PSIX, +1.13%
, which designs, engineers and builds engines that run on alternatives to gasoline, such as natural gas. (That stock soared 378% in 2013.) And Mr. Lynch has a taste for Krispy Kreme
KKD, -1.24%
doughnuts—the stock, not just the taste treats.

“This is a brand that ran into trouble overexpanding, that is now at the point where they can grow more intelligently and more profitably,” thanks in part to new baking technology that requires less space, he says.

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